Guaranteed income riders can be costly

Stan Haithcock, an independent agent who specializes in annuities, warns that sales pitches from annuities brokers often can be deceptive.

Photo: Drew Angerer /New York Times

Ask retirees to design the perfect investment and it surely would be a guaranteed paycheck for life, providing protection in the market’s darkest hours, yet allowing them to profit during upswings.

A product that claims to achieve all of this, and often more, already exists: It is called a variable annuity with a guaranteed income rider. The name itself, a mouthful, reflects its complexity.

Variable annuities are among the products most frequently sold to investors over age 65, according to a recent report by regulators, which also found evidence of potentially inappropriate sales to older investors at more than a third of the 44 brokerage firms examined.

The sales pitch can be hard to resist: Investors are guaranteed an income stream for life, with the possibility the amount will increase. If a retiree’s portfolio free-falls, no problem. He or she still will collect the same paycheck forevermore. That is because an insurance policy is attached to the investment portfolio, which guarantees the lifetime income.

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Before you buy …

Buying a variable annuity with a guaranteed income rider can be incredibly confusing — and many investors walk away with products that they don’t fully understand. Before making any decisions, consider the following:

Payoff: According to one analysis, by David Blanchett, head of retirement research at Morningstar Investment Management, these products often don’t pay off unless you collect the guaranteed income for at least 30 years.

Variety: Seek out independent financial advisers who can let you choose from a variety of products and who are not opposed to running options on how you might fare with other guaranteed income products,

Fees: These annuities carry annual fees of 3.54, on average, according to Morningstar. But that breaks down into a various charges. Some providers charge far less; the same goes for products found inside 401(k) plans.

Existing contracts: Variable annuities with guaranteed income riders sold before 2009 often provided much higher withdrawals rates. If you have one of those, it may pay to keep it or start collecting that income, said financial planner Mark Cortazzo. If the insurer no longer can meet its obligations, regulators typically first would try to find another insurer to take over the contracts. But if the insurer must be liquidated, the annuity holders or their beneficiaries would receive coverage, up to certain limits, through their state’s guaranty association.

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But all of these promises come at a steep cost — 3.5 percent annually, on average, and often higher — which will gnaw at even the best-performing portfolios over time.

So before signing any contracts, investors should first ask themselves if they fully understand what they are being offered. And then, they should weigh whether they could do better with a simpler investment.

Often, financial advisers say, the answer is yes. With many variable annuities, investors effectively pay more than 3 percent annually for the privilege of spending their own money. But older investors who want a guarantee they will not outlive their portfolio still may find them attractive, even though the products available today are far less generous than those sold before the financial collapse of 2008.

“The thing with annuities is you are paying for insurance,” said Mark Cortazzo, a financial planner who offers an annuity review service. “And as with most insurance products, it’s the worst deal for some people, and for others it’s the best thing they could have done with that money.”

Perhaps, but it is a notoriously complex product typically sold by people working on commission who are not usually required to put your interests ahead of their own. And it is nearly impossible for average investors to figure out if they are getting a reasonable deal without professional help. Changing your mind can be costly because many contracts carry hefty surrender charges, sometimes 7 percent of your portfolio or more.

Even Moshe Milevsky, an associate professor of finance at the Schulich School of Business at York University in Toronto who has studied the products extensively, said he had to consult with colleagues to figure out if he should add money to a variable annuity with a guaranteed withdrawal benefit.

“We needed two Ph.D.’s in math and some of their grad students to use their software normally used to analyze collapsing stars to figure it out,” he said, only half-jokingly. “I purchased it because I did the math and it looked like it was a good deal relative to other products.”

The money held in variable annuities with guaranteed income riders has doubled in the last five years to $843 billion in 2014, from $411 billion in 2009, according to the Limra Secure Retirement Institute, an industry research group. Sales were $67 billion last year, down from a peak of $96 billion in 2011, partly because some insurers have reduced their business.

So exactly how do they work — and how and when, if ever, should they be used?

Every contract has unique twists, but here is how a hypothetical variable annuity with a guaranteed income rider could operate. An investor makes an initial payment, say $200,000, which then is invested. The investor might choose to take withdrawals right away, or let the tax-deferred portfolio grow.

From here, it gets a little tricky. The size of the guaranteed paycheck is based on what you might think of as a “shadow account,” because its starting value mirrors the initial investment. But the shadow account, technically known as the benefit base, does not hold real money. It exists solely to calculate the amount of the investor’s paycheck.

The benefit base is usually guaranteed to grow by a set percentage, say 5 or 6 percent each year, until the investor starts collecting income. But if the investor’s actual portfolio is worth more than the base on a specific date each year, the benefit base will increase to that amount. If the market plunges, the real portfolio will suffer — but the shadow number and future paychecks will remain intact.

The guaranteed paycheck is a fixed percentage of the benefit base — perhaps 5 percent annually at age 65, or 4.5 percent for a couple — depending on the investor’s age when the income begins. The paychecks and hefty fees are deducted from the actual portfolio. If the portfolio is eventually depleted, the paychecks will continue based on the shadow account’s value, just as they always have.

“I think of it as drawdown insurance,” said Timothy Holmes, principal and head of Vanguard’s annuity and insurance services, which offers variable annuities and guaranteed income riders with total annual costs, about 1.75 percent, that are well below the industry average. “If the sequence of returns in the market are such that you deplete your assets, the insurance would pick up the payments going forward.”

There are far simpler annuities that initially may provide more generous income streams, including immediate or deferred-income annuities. Investors in those annuities hand a pile of money to an insurer, in exchange for a guaranteed paycheck for life, either right away or at some date in the future. But many investors balk at parting with so much money forever.

Some variable annuities with income riders, however, are far more flexible because investors can change their minds. If the stock market is strong — and a retiree decides she no longer needs the income guarantee — some riders or contracts can be canceled. However, many contracts charge harsh surrender penalties, which can last for the first seven years or longer so it is important for investors to know which kind they are buying.